And Now Back to Your Regularly Scheduled Program(?)

Mercenary Trader

Jun. 10, 2013, 10:48 AM

John Maynard Keynes once famously said: "When the facts change, I change my mind. What do you do sir?"

Last week we noted structural bearishness on Japan — due to the inevitable failure of Abenomics — and in turn expressed a bullish trading view on treasurys. That view shifted quickly after the "goldilocks" jobs report.

An ugly jobs report, coupled with meltdown concern in Japan, could have ignited a "risk off" fireball that powered bonds higher. But we didn't get that.

Instead, the potential power of a one-two bearish combo was negated by an almost ideal result on the US employment side.

Not ideal in terms of a healing US economy, but rather, a sickly-yet-improving economy that remains just weak enough for the Fed to stay its hand…

This result led to UST whackage, a surge in the major US indices after holding 50 EMA support, and a strategic about-face on our part. (We are traders - this is what traders sometimes do.)

Heading into the new week, the outlook is decidedly bullish on the major US indices and dollar / yen.

As expressed last week, our view is that Abenomics will ultimately fail — run headlong into the brick wall of structural reform failure — but the key question is when.

If that failure is later, rather than sooner, it becomes possible for Japan to get multiple rounds of "can kicking" in, a la Europe, Greece and so on.

Last week's major drop in the USD versus yen was a function of long-side money managers getting blown out of Japanese equities and simultaneously covering their yen shorts.

The equity / yen pairing was a straightforward way to play Japan: Buy Japanese stocks, and short yen to both hedge your risk and gain access to a funding currency. (If you borrow in yen, you can buy the Nikkei with the proceeds.)

And so, when the Nikkei puked, leading to a round of frantic margin calls, the yen also spiked versus the USD as both sides of the trade got lifted. To sell out of long Japanese equity positions was simultaneously to cover shorts.

Why is this bullish, then, for dollar/yen? Three reasons:

After a major short squeeze in the yen, the weak hands (exposed shorts) have been taken out. It is a normal function of markets to "clear' or "thin out" a popular trade with an occasional violent reversal, which eases buying or selling pressure. Once that pressure has been released — if the fundamentals remain strong — it becomes easier for the dominant trend to reassert itself.

Abe and Kuroda have everything riding on a weaker yen. The powers that be in Japan simply cannot tolerate excessive yen strength. It runs counter to the whole concept of Abenomics. Japan's current leadership has vocally and aggressively gone "all in" on Abenomics as the last best hope for Japan. That means they will see an untenable yen rise as a fight to the death. This is one of those cases where you want to bet with the powers that be, rather than against them — at least in the intermediate term.

Underlying fundamentals for the USD (versus Japan — and Europe and China too for that matter) remain soundly bullish. As we noted in an earlier themes and trends piece, the USD may well have ended a ten-year secular bear market. Natural tailwinds for the USD are headwinds for the yen (which, remember, Abe and Kuroda want to see weaker anyway.)

A key question moving forward is whether the bulls can capitalize on the favorable situation that has materialized for them.

After a period of weakness and hesitation, it looks possible that:

Japan fears could be shaken off (at least for the interim)

The Federal Reserve could provide a sentiment "sweet spot"

Technicals could confirm a thrust higher on corrective channel breakout

In other words, if Japan volatility is absorbed, it could be "and now back to your regularly scheduled program" for a US-focused emphasis on risk assets (assuming bulls can follow through here).

On a separate note, the below emerging markets chart was tweeted out last week:

Weakness in China (where we are short FXI) is confirming the increasingly dire fundamental outlook for emerging markets.

A combination of falling commodity prices, overbought real estate sectors, huge overspending on capital infrastructure, and over-investment on the part of multinationals — combined with a strengthening outlook for the USD and the US economy vis a vis the rest of the world — all mean that emerging market economies have some very cold winds blowing in their face.

"…There will come a point where people will say, "This is it; we're advancing." And people will actually pile into equities. As one person described it to me, after a crisis, it is kind of sexy to be skeptical. But as an investor, you have to remain somewhat dispassionate about the environment and just look at what is going on and accept it for what it is. People haven't been able to do that in the past several years.

"…People continue to overestimate the risks in the U.S. I would argue that they grossly — and I'm not using that word lightly — underestimate the risks in the emerging markets. A lot of the problems that people think are inevitably going to crop up here, including inflation and out-of-control money growth, are actually happening in the emerging markets. We aren't seeing those risks here. But the thinking is that it is inevitable and it has to happen here. A lot of people have talked about how the great rotation will be a shift from bonds to stocks. But that's not right. The great rotation — and the biggest decision you have to make for your portfolio — is that for five to seven years, it is not going to be bonds to stocks, but rather non-U.S. assets to U.S assets. We are maybe in the fourth inning of a secular period of outperformance for U.S. assets. Think about this: The Standard & Poor's 500 has outperformed emerging markets now for five years. Nobody cares, and it pains people to admit that the U.S. market has been outperforming.

"…The hyperbolic credit creation in China has gotten worse… and the money supply problems in India have gotten worse, as have the corporate fundamentals in China. The Chinese corporate sector is now one of the most levered in the world, and its marginal return on investment is going down. So the efficiency of that economy's credit is getting lower and lower. That's not healthy; that's not a growth story. Expectations are too high. In 2012′s fourth quarter, just under 60% of emerging-market companies reported negative earnings surprises, compared with 28% in the U.S. And the corporate fundamentals in emerging markets continue to erode.

"…The consensus has been that you should buy large-cap multinationals, but as I said, people have grossly underestimated the risks in the emerging markets. And the large multinationals' plan is to try to grow through the emerging markets. Why would we want to be exposed to the biggest area of the global credit bubble that has yet to deflate? That makes no sense to us. If you start playing more domestic-oriented U.S. companies, you naturally start going down in market cap. So that's what brought us to smaller and mid-cap companies. That's naturally pushing us away from large-cap stocks."